Definition

The term Pigovian tax refers to a tax that is levied against companies that create excess social costs through their business processes, products, or services. Pigovian taxes are oftentimes deemed an effective way to correct for what are referred to as "negative externalities."

Explanation

Also known as a Pigouvian tax, the British economist Arthur Pigou explained in his book The Economics of Welfare how industrialists place their private interests ahead of social interests. That is to say, there is no incentive for companies to spend additional funds to mitigate the harm they might be causing society either through the processes they use or the goods they produce. Pigou argued an efficient way to correct for this harm would be through a tax on that business or industry.

For example, coal can be used as a fuel source when producing electricity. While the energy itself does no harm to society, the process of burning coal produces air pollution, which is a negative externality. As long as coal can produce energy inexpensively, there is no incentive for companies to switch to cleaner fuel sources. A Pigovian tax, such as a carbon tax, could be used to not only incent companies to reduce the amount of coal burned, but the funds collected through this tax could also be used to help clean up the environment.

Pigovian taxes can also be applied to end products, discouraging consumers from purchasing certain goods or services. For example, a Pigovian tax on cigarettes and alcohol lowers the consumption of products considered harmful to society.